Great blog posts about macroeconomics

Too Big to Fail

Normally when a corporation or institution fails, it is allowed to go under and suffer the responsibility of their poor choices. However some institutions are so large that their failure would cause systemic shocks and drive the economy into a free-fall. As a result, companies such as Bank of America, Goldman Sachs, JP Morgan, Morgan Stanley, Citigroup, and Wells Fargo have become known as “too big to fail”. These banks, by virtue of their magnitude and holdings, cannot be safely “wound down” without incurring serious negative externalities and negatively affecting the economy. This investigation will focus not on federal housing policy, Federal Reserve interest rates, GSEs, mortgage-backed securities or collateralized debt obligations, which were the vehicles for the crash. Institutions ran into trouble during the financial crisis because of their participation in such industries (and the complicity of the federal government in precipitating the housing bubble). The key problem was that certain actors were “too big to fail” and as thus required the government to step in; this is an investigation of the problem that occurs when institutions are “too big to fail” and what caused them to grow to that size.

There are a few key pieces of legislation that need to be understood for their effect on the “too big to fail” banks that contributed to the 2007-2008 financial crash (and allowing them to grow to the size that they did). The Financial Services Modernization Act of 1999 and the Commodity Futures Modernization Act of 2000, signed under the Clinton administration, had significant impacts. The Financial Services Modernization Act of 1999, known as the Gramm-Leach Bliley Act, removed derivatives from meaningful regulation—this contributed to the situation of AIG, which had to be bailed out by the government to the tune of $85 billion. The second act, the Financial Services Modernization Act of 1999, most significantly repealed the Glass-Steagall Act which was part of the U.S. Banking Act of 1933. The Glass-Steagall provisions separated investment and commercial banks, the former being excluded from the Federal Reserve and therefore not government-guaranteed. The repeal of the Glass-Steagall provisions was the result of a $300 million lobbying effort from the banking industry, and their investment allowed them access to more and more potential revenue streams, albeit at the expense of mixing depositor and investor money.[1] The Citibank-Travelers merger of Citigroup, turning the former commercial holdings company into a banking, securities, and insurance conglomerate, epitomizes the most poignant product of this repeal; they required multiple capital infusions after over-leveraging themselves and engaging in the high-risk subprime market. Also, in April of 2004, the Securities and Exchange Commission increased the leveraging index (or debt to capital ratio) for the big banks from 12:1 to 30:1 (and even higher).[2] In 2000, the Commodity Futures Modernization Act, immunized derivatives from state and federal gambling laws; the legislation also exempted credit default swaps from regulations that were put into place under the Securities Act of 1933. This all allowed these massive institutions to become, in essence, gigantic hedge firms using depositor money (counted as capital requirements) for speculative purposes and helped them become “too big” as well as sowing the seeds “to fail” through their involvement in the high-risk subprime mortgage market through mortgage-backed securities and collateralized debt obligations.

If one of these “too big to fail” banks is facing failure, it threatens the solvency of other financial institutions connected to it. Institutions which rely upon the bank or creditors for their own operation face insolvency or failure—from here proceeds “contagion”, where the failure spreads throughout the economy, drying up lines of credit and financial services. This can cause a recession, or even a depression as seen in 1929. The idea behind “too big to fail” bailouts is that by backing uninsured deposits, credit will not dry up and the risk of systemic failure can be prevented.

Upon first consideration, the idea is warranted—in an economy that desperately depends on the credit, and financial services provided by these institutions, preemptive action can prevent economic catastrophe. However, the “too big to fail” doctrine has side effects in which the seeds of economic destruction are sewn. There are three critical problems: it engenders extreme moral hazards, fosters an anticompetitive “free” market, and their size causes severe negative externalities and systemic shock if they fail. All three of these problems fall under what is the most critical issue at play here: “too big to fail” policy causes a self-perpetuating cycle.

Moral hazard refers to a situation where an institution will engage in risky speculative behavior because they are insured against the ill effects their wrong choices result in. The insurance in this case comes in the form of “too big to fail” bailouts, which results in reduced monitoring by credit agencies and a rise in risky behavior taken by the firms.

Because these “too big to fail” banks are backed by the government, investors naturally see them as a safer investment than smaller, independently-owned banks. When the FDIC nominally only insures $100,000 (or $250,000, as is the short-term case), investors are naturally going to be attracted to banks which have that additional “too big to fail” guarantee.They can afford to offer investors lower interest rates than the small banks, because of that guarantee. They also receive a much lower interest rate on cost of funds when borrowing capital. A 2009 study by the Center for Economic and Policy Research found that the “too big to fail” banks received this form of credit at an interest rate of 1.15%, while smaller banks paid 1.93%-a difference of 0.78%.[3] Due to the result of “too big to fail” guarantee, and the effect it has on these available credit lines, the ten largest banks, according to Bloomberg News, receive an implicit taxpayer subsidy of $83 billion annually.[4] A study by the Federal Reserve Bank of New York on bond rates from 1985-2009 discovered that the average cost savings on bonds issued for the largest banks compared to their peers was approximately “$60 million, or 91 basis points…compared with the benefit that a similarly large nonbank enjoyed compared with a smaller peer.”[5]

The government’s guarantee to bail out the banks (due to the risk of systemic failure if they do not do so) also drives the banks to grow to the point where they are considered “too big to fail”. Banks have shown a willingness to pay premiums for acquisitions that put them into that territory. The Federal Reserve Bank of Philadelphia conducted an investigation over the span of 1991-2004 concerning this premium and found that the eight banks that crossed the threshold paid “at least $14 billion in added premiums” to reach the “$100 billion in assets” that solidifies them as “too big to fail”.[6] As this paper has noted, reaching this threshold allows them to engage in high-risk speculation without worrying that their choices will result in their insolvency. As the firms grow bigger, their significance to the economy as a whole does too, resulting in a bailout when they fail. It is a self-perpetuating cycle of destruction that, as long as the banks are “too big to fail” will continue.

Since the crash, the biggest banks have only gotten bigger: at the end-of-year 2012, the six largest banks held assets of $9.576 trillion—to put it in perspective, it is equivalent to 59% of the 2012 GDP (which was $16.245 trillion).[7] Even with the passage of Dodd-Frank, significant legislation and regulations need to be enacted in order to prevent another financial crash; the cycle is engendering itself again.

The fact of the matter is, the banks should not be in a position where taxpayers have to bail them out or risk economic collapse due to the large negative externalities caused by failure. “Too big to fail” has created a culture of recklessness that fosters high-risk investments because of government guarantee. These “too big to fail banks”, despite their irresponsibility, are incapable of being held accountable by virtue of their size. Immediate action must be taken in order to address the three issues of moral hazard, anti-competitiveness, and self-engendering destruction or we will find ourselves faced with the same problem merely years down the road.

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2 thoughts on “Too Big to Fail”

Nice post. Instead of footnotes, it would be great if I could link directly to your sources straight from the blog post. I bet any decent blogging platform allows you to include hyperlinks right in the text.

Anyway, what is your solution to the “too big to fail” issue? Should we break up the banks until the are no longer too big, or should we more tighly regulate them, or should we tax them more highly due to the externality involved?

I thought you did a great job in giving the short version of a terribly long and painful story. Your post gives an accurate description of the major terminology involved with TBTF, and your definition of the terms helps the reader understand the crisis, its main players, and what they did wrong. I agree with your concluding statements that the TBTF banks should not be in a position where if needed, tax-payers must come to the rescue to avert their demise. However, the insanely high level of interconnectedness amongst big banks keeps that threat alive, and supports the notion that it would be extremely difficult to dice them up into smaller entities. In addition to lower leverage ratios to keep these firms acting with the least amount of moral hazard, an even deeper(than already exists), comprehensive regulatory reform across the financial sector could aid in devaluing the threat or damage of a bank collapse, or even complete aversion of said collapses. By hammering banks with harsher rules, the SEC could eventually gain enough grip on the banks’ activity to bring the possibility of collapse to a dull roar, providing comfort to tax payers and investors alike.